Portfolio Manager Commentary Q2 '16

Everlasting

The Everlasting SMA model portfolio trailed the S&P 500 by 0.3 percentage points in the second quarter of 2016, putting the portfolio down 4.9 points relative to its benchmark year to date. Strong performances from LinkedIn, Zillow, and National Oilwell Varco were not enough to overcome the rest of the portfolio being flat to slightly down for the quarter.

The EP SMA is built on the philosophy of owning the stocks of great businesses with excellent management teams for a very long time. Over the short term, sometimes our resolve comes under pressure, especially during volatile times. The stock market has given investors a series of ups and downs since the fall of 2015. And the EP SMA hasn't recovered as quickly as the market since the swoon at the end of the first quarter. It's no fun to trail the market, but we have not lost confidence in our process nor in the companies that make up the portfolio.

The EP SMA holds the stocks of companies like Facebook, Starbucks, Under Armour, and many others. That's a portfolio of high-quality companies and managers that we believe have incredible potential over the next decade. And despite the recent declines in the prices of their shares, the businesses continue to get stronger.

Your managers were fairly active during the quarter. We purchased addition shares of LinkedIn, TripAdvisor, Tractor Supply, Under Armour, Priceline, and Nike at prices that we felt were attractive. We sold our shares of LinkedIn following its acquisition by Microsoft. We used the resulting capital to establish new positions in Amazon.com and PayPal.

Both of those business fit the EP model, and we are excited to bring them into the fold. Led by Founder and CEO Jeff Bezos, Amazon.com continues to use its advantages to become a better retailer, the leading computing services provider, and a developer of new technologies. PayPal CEO Dan Schulman continues to lead the resurrection of the digital payments company by investing heavily in product development and acquisitions to ensure that PayPal is there whenever a digital payment is made. We look forward to owning these incredible businesses for many years.

We don't expect to be this active every quarter. The market offered us the aforementioned opportunities, so we made the most of them. We will continue to stay the course, no matter what's happening in the market. That means investing in the best business with the best managers and the brightest long-term prospects. We will work hard to purchase shares at reasonable to attractive prices, and our preference will be to hold them for many, many years. That's been a proven method to deliver positive investment returns.

Thank you for trusting us with your hard-earned capital. We look forward to serving your investment needs for many years to come.

International

Note: Just prior to our publishing this update, ARM Holdings, a constituent of the International SMA sleeve which we discuss below, announced that it had agreed to be purchased by Japanese conglomerate Softbank for £24.3 billion ($32 billion) in an all-cash deal. The deal is subject to approval by ARM Holdings Shareholders, but otherwise has no anti-trust or regulatory conditions.

International markets ended the second quarter roughly where they started, but that is only part of the story.

Of course, the Brexit vote on June 23rd roiled markets, sending the London indices down more than 5% in one day, and sparking sympathy drops in markets around the world. Then, as quickly as it came, the panic was gone, and most markets regained nearly all their losses by the end of the month.

While we wouldn't be surprised to see more volatility as the world figure class="commentary strat">s out just what Brexit means, we aren't overly concerned about the long-term fate of the UK or its impact on our international investments.

The only British company we own is ARM Holdings, which designs processors found in nearly every mobile phone in the world. Assuming the trend of increasingly connected devices isn't derailed by the UK's politics (which is our running assumption), they should be fine.

Should global economic growth be materially impacted by the goings on in the UK and Europe, the companies in the International strategy will likely suffer in the near term, but we believe we've invested in strong companies that can not only survive near-term ructions but thrive in years to come.

Over the past three months the International SMA returned 1.0% versus a -0.2% loss for its benchmark; year-to-date those numbers are 1.6% and -0.5%, respectively.

Two-thirds of the companies in the International SMA were up in the second quarter with four - Core Labs (an oil services company that helps oil producers produce more for less), Medtronic (one of the largest medical device manufacturers in the world), Tencent (one of the tech giants of China), and Sberbank (the largest bank in Russia) - up more than 10%.

Once again, Sberbank was the strongest performer in the portfolio, returning almost 26% since March 31st and 51% over the past six months. We'll bet you were never so happy to be owning a Russian bank!

At the other end of the spectrum, Fast Retailing's stock had another tough quarter even as the company has seen improving trends in their home market (Japan) since their disappointing mid-year numbers were released in February (their fiscal year ends in August).

Despite its current struggles, we have confidence in Fast Retailing's management team, and expect this company's performance - and its stock price - to improve in the coming years.

We have no idea what excitement the next quarter (or year) will bring (for the UK, Europe, or any number of other countries), but it is a safe bet we'll have more periods of market worry. But we say, "Let the market worry". Your investing team is confident we've collected a group of companies that can handle whatever comes our way.

Large Cap Core

The Large Cap Core SMA trailed its benchmark, the S&P 500, by 0.8 percentage points during the second quarter of 2016. That puts the portfolio 1.8 points behind the index year-to-date. During the quarter, the portfolio benefitted from strong performances from LinkedIn, Amazon.com, and energy-related stocks Devon Energy and National Oilwell Varco. Apple, IPG Photonics, and Borg Warner were the largest drags on performance during this time period.

The stock market has been volatile since the fall of 2015, with steep declines in August 2015, February 2016, and most recently following the Brexit vote. Our blended investing strategy of growth, value, and income has been relatively more steady than the market over that time frame. But while the swings in the portfolio may be more muted that the market's overall, our portfolio continues to slightly lag in performance.

We would prefer to outperform the market during every time period. Unfortunately, we won't. However, what we can and will do is adhere to the Large Cap Core SMA investing philosophy of owning great businesses at attractive prices and building a portfolio across a variety of investments. We remain confident that the strategy should be able to deliver solid long-term returns with fewer ups and downs.

Market downturns, like we saw in February and following the Brexit vote, don't help the portfolio and aren't much fun to experience. However, they do provide opportunities for us. During the quarter, we purchased additional shares of LinkedIn, TripAdvisor, Under Armour, PayPal, and Apple. We also initiated positions in Nike, CVS Health, and Disney, after selling shares of LinkedIn (following its acquisition by Microsoft) and ExpressScripts.

In the former group, your team used the price declines to purchase additional shares of great businesses we know. With the latter group, we've added a few more excellent companies to the portfolio. The Large Cap Core SMA team believes these purchases fit squarely within the portfolio's investing strategy and should produce solid returns with lower volatility over the long term.

Here is a quick note about our decision to sell ExpressScripts and purchase shares of CVS Health. Both of these healthcare names are excellent companies. And both are in the pharmacy benefits management market, with ExpressScripts being the largest. Comparing the two companies, we believe that CVS Health provided the best mix of business quality, future growth, and stock price attractiveness. As such, we decided to "upgrade" the portfolio by swapping shares of ExpressScripts with CVS Health.

Going forward, we will look to take advantage of attractive prices in the market. And your team will be working hard to make sure the portfolio has the right balance of risk and reward.

Pro

For the second consecutive quarter the market has had a rash sell-off, only to storm back higher still. This time around, the fall centered on the surprise United Kingdom vote to exit the European Union. The whipsaw has been dramatic, reflecting the "ready, fire, aim" mentality that our steady strategy aims to combat.

The Pro SMA Strategy entered the quarter about 65% net long, with a 10% market hedge in place and a handful of direct short positions. These positions provided stability amidst the turbulence but have taken divergent paths since the storm's climax. Our market hedge has roared back over 9% since its "Brexit" closing low and has been a drag on performance. Still, it is doing its job as protection in the event of a large market-wide decline, and while this protection isn't free, we're happy it is in place. Our direct shorts were all positive contributors to performance for the quarter, with our short of cruise line operator Royal Caribbean dropping (which benefits us as short sellers) more than 16%. The company's management continues to over-promise and under-deliver, which we believe is par for the course because of industry overcapacity and an immense cost to attract customers.

As we wrote in our Q4 commentary, and mentioned again last quarter: "We're not big on prognostications, but it seems like volatility may be a big story in 2016. For us, this means an opportunity to use option strategies more and be opportunistic in our search for great businesses to own for the long term." The first statement appears prescient, but more importantly, we have begun to use option strategies more frequently. We have established a small put writing sleeve, fully backed by available cash, to earn income and make our idle cash more productive. Thank you, volatility. We will continue to use this strategy in a disciplined way where premium attractiveness intersects with great businesses at decent valuations.

Our strongest performer for the quarter was pizza joint operator and franchisor Papa John's International, which increased more than 25%. Nothing much has changed in the business of delivering quality pizza, but investors have bid the shares up. Another top performer was global medical device giant Medtronic. The company's fiscal year end results were strong. In our eyes, CEO Omar Ishrak deserves a heap of credit for repositioning the company for growth, instilling an operating discipline, and formulating a sound strategy for dealing with an evolving global healthcare landscape.

TD Ameritrade, Apple, and Swatch were among the worst performers (down between 10% and 15% on the quarter). The common thread here is that each company's business is in the "not working right now" bucket. Ameritrade's earnings power is tied to rising interest rates (which aren't rising), Apple's profits are tied to new product innovations (which are in a lull), and Swatch's sales are tied to Chinese consumers (who are spending less on expensive watches). On the flip side, each company generates prodigious cash flow and has an attractive valuation.

Large Cap Aggressive Growth

The Large Cap Aggressive Growth SMA portfolio outperformed the S&P 500 by 0.15 percentage points during the second quarter of 2016., the portfolio is still trailing the S&P 500, down 7 percentage points year-to-date. Rest assured, your team is well aware of the situation and has been making some portfolio changes in order to make further progress relative to the benchmark's performance.

The drawdown in the first quarter continues to take its toll on performance in 2016. However, as mentioned above, the portfolio has been recovering over the past few months. LinkedIn, Zillow, and Amazon.com were the big contributors in the second quarter. IPG Photonics, Under Armour, and Ionis Pharmaceutical were the big detractors to second quarter performance.

The Large Cap Aggressive Growth strategy centers around investing in innovative companies with strong management teams and tremendous growth opportunities. These are companies that are looking to build new products that have the power to change industries, change lives, and even change the world. While of course we try to make sure we are investing in high-quality companies, we're willing to take a little extra risk if we believe the potential payoff is large enough.

Recently, a few companies in the Large Cap Aggressive Growth SMA portfolio have experienced some short-term setbacks. The market does not take kindly to companies underperforming high expectations. That's why your team has been going through each and every business in the portfolio to make sure it meets our quality and risk/reward standards. And we've made some changes as a result.

We sold our stake in SolarCity after seeing some changes in the quality of its business model, coupled with a landscape that's becoming significantly more competitive. We also sold our shares of ExpressScripts, but for different reasons. ExpressScripts remains a very strong franchise. But we found an even better opportunity within the healthcare space in CVS Health. So we "upgraded" the portfolio by buying shares of CVS Health, as it has better growth prospects going forward and an attractive price.

We also sold our shares of LinkedIn following the announcement that it will be acquired by Microsoft. We used the funds from the windfall, as well as the excess cash in the portfolio, to purchase additional shares of TripAdvisor, Ultimate Software, Under Armour, Ionis Pharmaceutical, Priceline, PayPal, and Disney. These are all excellent businesses of which we are happy to own more.

We also initiated positions in Splunk and Nike. Although Nike is a household name, Splunk is not. The best way to describe Splunk is that its technologies help businesses create value from all of the data they collect. The company is a leader in its space, has an experienced management team, and has incredible growth prospects ahead of it. We are happy to own both of these high-quality businesses.

We expect market volatility to continue in the near term. As such, we've decided to upgrade the quality of the portfolio a little bit by adding capital to some of the strongest businesses we currently own, as well as a few we didn't own before. Your team will continue to attempt to populate the portfolio with companies that we believe have the best balance of quality and innovation in order to produce the best long-term returns possible.

U.S. Small & Mid-Cap

During the second quarter of 2016, the SMID model returned 0.3% compared to a gain of 4.0% for its benchmark, the S&P 400 Index. During the quarter we had several companies within the tech, healthcare, and industrials sectors report disappointing first quarter results and in aggregate this contributed to the model underperforming its benchmark.

Two of our laggards in the quarter were Infinera and Proto Labs, which declined 29% and 25%, respectively. These are companies that have lumpy ordering cycles from their customers, which can cause volatility in quarterly results. For some context, Infinera grew Q1 revenue 31% year over year to $245 million and Proto Labs grew its revenue 24% to $73 million. Those are robust growth rates, in our view, but they fell short of the market's expectations and the stocks sold off. We consider this to be a first class problem. We remain excited about the competitive positioning of both of these businesses and their long term prospects.

The portfolio continues to have large exposure to the consumer discretionary sector and many of our businesses within that sector are performing quite well. Drew Industries is our largest holding and its shares were up 32% during the quarter. Drew is a dominant supplier of parts to RV manufacturers, one of which is another of our sizable consumer discretionary holdings, Thor Industries. Since 2009, annual RV unit sales have grown by 14% per year according to the Recreational Vehicle Industry Association. Sales have remained strong with unit growth of 10% through the first half of this year. There are a lot of favorable trends in place for the RV business including low borrowing costs, cheap gas, and retiring baby boomers.

There were only a handful of trades during the quarter. We increased our stake in Church & Dwight, a company that, in our opinion, is a fantastic consumer staple business. Church & Dwight owns dozens of prominent brands including Arm & Hammer, Orajel, OxiClean, and Trojan. These are the types of products that consumers purchase regularly and are willing to pay a premium for due to the brand strength.

During the quarter we initiated new positions in Watsco and Pebblebrook Hotel Trust. Watsco is the country's leading distributor of heating and air conditioning units and accessories. When a home owner has their A/C go down in the middle of the summer they want it fixed quickly and affordably. Watsco supports the contractor doing repairs with a broad catalog of products and hundreds of delivery vehicles. The company is currently making significant investments in technology that will allow it to serve contractors more efficiently. We expect this will result in higher profit margins and expanding market share as Watsco's competitors lack the scale to match this technology investment.

Pebblebrook is a real estate investment trust that purchases, renovates, and makes operational improvements at upscale and luxury hotels. They focus on acquiring hotels in locations where it is difficult for competitors to build similar properties due to dense urban infrastructure and geographical constraints. We believe the unique nature of their properties is a lasting competitive advantage.

U.S. Small & Mid-Cap Dividend

During the second quarter the SMID Dividend model returned 4.4% compared to the return of 4.0% for its benchmark, the S&P 400 Index.

At quarter-end, financials were the largest sector in the model, comprising 26% of assets. Most of our financial holdings are real estate investment trusts and these businesses appreciated strongly in the quarter. Agree Realty, Alexandria Real Estate Equities, Healthcare Realty Trust, Stag Industrial, and Tanger Factory Outlet all had gains greater than 10% for the quarter.

There are segments of U.S. commercial real estate that are aggressively valued in our analysis. In this environment it is crucial that the management teams at the REITs we own be disciplined acquirers of assets and deliver growth adjusted for the per share dilution that occurs when equity is used to finance acquisitions.

Laggards in the portfolio were on the consumer discretionary side, with shoe retailer DSW and off-road vehicle manufacturer Polaris down 22% and 16% respectively. These businesses are quite different, though the near-term obstacles are similar in that their customers are not buying as many shoes or snowmobiles as we'd like. Consumer demand will ebb and flow from one quarter to the next and we will give their Q2 earnings reports a close look when they are released in a few weeks. We continue to hold these businesses because we do not believe that the current difficulties are indicative of long term business quality impairment.

We only made one trade during the quarter and that was to sell out of H&R Block. We admire what CEO Bill Cobb has been able to accomplish over the past five years with streamlining H&R Block's business to focus solely on tax preparation. However, the company's competitive position looks to be in permanent decline given the success of industry juggernaut TurboTax and a plethora of free electronic tax filing providers. We stress the importance of owning businesses that will be stronger in five years than they are today, and our view is that H&R Block is no longer likely to meet that standard.

At quarter-end, the model had a dividend yield of 2.6% compared to 1.75% for the S&P 400. Over the past year, the dividend growth rate for the model was 8.4% versus 3.1% for the S&P 400. These metrics are outcomes of our investment strategy for this model. We aim to own what we believe are high quality businesses that have the ability to grow and increase their dividends over time. Future dividend growth prospects are just as important to us as the current yield. We are happy with where the portfolio currently stands relative to its benchmark on both measures.